At the outset, 2016 was underscored by sharp declines in many risk assets amid concerns over global growth, continued oil price weakness, and the pace of slowing growth in China. Through February 11th, the S&P 500 was down 10.3% year-to-date and U.S. Treasury yields out the curve had fallen significantly as investors sought safe havens. However, market sentiment improved and risk assets recovered as large central banks took action, including the Bank of Japan’s (BoJ) introduction of negative interest rates for the first time in its history. Expectations that the Federal Reserve would likely take a more measured pace of policy rate hikes also helped stabilize markets. Later in the calendar year, the markets faced heightened political uncertainty domestically and abroad. The U.K.’s June vote to leave the European Union surprised markets, as did the U.S.’s election of Donald Trump in November. Both events caused local equity markets to initially decline before gaining ground shortly after. Despite these major developments, several equity indices hit record levels in 2016 and measures of U.S. and European equity volatility ended the year lower than where they started the year, even though there were wide fluctuations.
In March, the European Central Bank (ECB) instituted a number of broad stimulus measures, which included cuts to all major reference rates, an expansion of its quantitative easing program to lower borrowing costs, and a new targeted long-term refinancing program aimed at encouraging bank lending. The BoJ announced a series of aggressive moves, beginning with the introduction of negative rates on January 29th. Nine months later, the bank announced a significant policy overhaul, including its goal to overshoot its 2% inflation target and an initiative designed to keep the 10-year yield on Japan government bonds at zero percent through bond market transactions. Following the June Brexit vote, the Bank of England took steps to ease monetary policy, which helped stabilize the economy and the local equity markets. However, the sterling continued to sell off sharply and ended the year down 16% versus the U.S. dollar (USD). Conversely, the Fed remained on hold for much of the year, gradually dampening expectations for future rate hikes. As expected, the Fed instituted a rate hike in December. However, it surprised markets by projecting the possibility of three rate hikes over the course of 2017—one more than markets were expecting.
While the U.S. Treasury yield curve ended 2016 modestly higher, this masked significant moves throughout the year. In July, the U.S. Treasury 10-year yield closed at a record low of 1.37%. Yields marched higher and the 10-year ended the year at 2.45%—18 bps higher than where it began. U.S. sovereign yields remained well above those of other large developed markets. The percentage of U.S. Treasuries held by foreign investors trended down over the year after remaining relatively stable in recent years. The decline was driven primarily by an increase in U.S. Treasuries outstanding and a reduction in China’s U.S. Treasury holdings. In 2016, China drew on their foreign reserves in an effort to prop up the yuan, and its U.S. Treasury ownership declined $130.4 billion year-over-year as of October 31st. Japan overtook China as the largest foreign holder of U.S. Treasuries at $1.1 trillion.
Outside of the U.S., several other developed market sovereign yields hit historic lows following the Brexit vote. By the end of June, the market value of negative-yielding government bonds, in aggregate, reached $11.7 trillion. An incremental $1.3 trillion was added to the overall tally on the back of Brexit, according to data released by Fitch Ratings. Sentiment shifted in the fourth quarter and most developed market yields increased amid firming growth and inflation expectations. Global yields experienced additional pressure following Trump’s unexpected victory. Nominal U.S. Treasury yields and market inflation expectations rose on the belief that many of Trump’s policies could be inflationary and lead to an increased fiscal burden. These views led to the market pushing interest rates higher along the yield curve. While the 10-year breakeven inflation rate rose 40 bps to 1.8% during the year, it still remains below its long-term average of 2.0%.
Amid this backdrop, the traditional 70/30 mix—70% domestic equities (S&P 500)/30% fixed income (Bloomberg Barclays Aggregate) portfolio —gained 9.2% in 2016. This mix outperformed the 5.9% gain of a broader diversified portfolio mix, which incorporates non-U.S. developed and emerging markets (EM) equities, private equity, real assets, hedge funds, and non-U.S. bonds.
Diversified portfolios were aided by components of the real assets segment, particularly mining equities (+57.0%), energy equities (+30.8%), and commodities (+11.7%), all of which delivered negative returns in the previous two calendar years. Crude oil (WTI) advanced sharply (+45%) during the calendar year following two years of double-digit declines. The advance was driven by: (i) declining U.S. production due to the lagged effect of two years of falling rig counts, (ii) continued growth in global demand, (iii) the belief that Organization of the Petroleum Exporting Countries (OPEC) was pumping supply at or near maximum capacity, and (iv) sentiment that a rebalancing of global supply and demand was underway. In September, OPEC’s preliminary agreement to cut production supported oil prices, but skepticism that a final deal could be reached and adhered to remained. The cartel finalized an agreement to cut in November—the first since 2008. This action propelled oil prices to the mid-$50 range by year-end, but well below 2007 to early 2014 levels.
Metals and mining equities also advanced strongly, rallying 57.0% (as measured by the MSCI World Metals and Mining Index) on sharply higher industrial metal commodity prices. Industrial metals prices increased 19.9% (as measured by the Bloomberg Industrial Metals Index) on stronger global demand. In particular, Chinese demand grew as a result of stimulus measures, including increased infrastructure spending, easing lending standards in the property market, and cuts to taxes on auto sales. Finally, expectations of higher infrastructure spending and generally pro-growth economic policies by the incoming Trump administration helped propel metals and mining equity valuations.
The broader U.S. equity market proved resilient, with the S&P 500 reaching all-time highs during 2016. Overall, the index rose by 11.9% for the full year, rallying approximately 25% on a cumulative basis after the February 11th low. Improving U.S. economic data and a stabilization of earnings helped equity markets overcome an uncertain political climate and uninspired global economy. Trump’s election sparked a rally near the end of 2016, as investors digested the potential impact of key focus areas of his campaign, such as economic and job growth, less financial regulation, lower corporate taxes, and revised trade agreements. Small cap stocks responded strongly, with the Russell 2000 Index up 20% for the year. However, a recent Financial Times article noted that actively managed equity funds continued to suffer in 2016, with more than $358 billion of outflows during the year as investors shifted further into passive strategies. Assets managed under passive mandates surpassed $5 trillion for the first time on record.
European stocks wavered during the year over concerns about the continued lack of growth, the impact of the ECB’s negative interest rates policy on its banking sector, the implications of Brexit, and the looming political elections, particularly in Germany and France. Currency also served as a headwind, in aggregate, for non-U.S. developed market returns—despite helping in the first half of the year as the USD declined modestly versus a handful of large developed markets currencies, such as the euro, Swiss franc, and Australian dollar. The negative impact of the rising dollar on non-U.S. developed equities was also less meaningful than it had been in the previous two calendar years. EM stocks posted double-digit gains as the MSCI EM Index rose 11.1%, modestly underperforming the S&P 500. In aggregate, currency served as a modest tailwind for EM equities after detracting significantly in 2015 and 2014. Despite these gains, the path was marked with a high level of volatility. The rebound in commodity prices during the first quarter spurred rallies in many commodity-centric countries, including Brazil, Peru, and Russia. However, sentiment shifted sharply in the week following the U.S. election and the MSCI EM Index fell 7.0% on concerns over Trump’s campaign stance on trade policy and immigration, as well as the prospect of policy rate hikes and USD strength. EM currencies also experienced a sharp sell-off post-election, with the Mexican peso among the hardest hit.
Once again, hedge funds failed to keep pace with the broader equity market, which held back the returns of the diversified portfolio. While there have been moments of brief volatility in the post-crisis bull market, there has not been a prolonged period of negative equity market performance. This market dynamic has been difficult for many hedge funds, where short attribution has been a drag on performance. With the exception of 2011, 2016 was the worst year for hedge funds since 2008 and funds captured less upside in the equity market than prior bull market years. The HFRI Fund Weighted Composite Index was up approximately 5.4% in 2016, with mixed strategy results.
Long/short managers began the year with a stiff headwind of negative performance. January and February losses were fueled by the reversal of widely held growth-oriented health care and technology names, and most managers failed to participate in the March rally in mining, energy, and lower-quality companies. Another key headwind was the sector reversal from technology to financials following the U.S. presidential election. After the first quarter, longs were generally positive, led by energy, technology, and financials, but failed to add alpha relative to the broad equity market. Short performance also hurt on an absolute and relative basis over the year. Health care was another challenging area for managers. Early in the year, Valeant Pharmaceuticals fell 74% as it faced an investigation related to its accounting practices and the sector traded off. Also, managers had to navigate the dissolution of the Pfizer/Allergan deal and uncertainty surrounding the U.S. presidential election.
On the positive side, merger-arbitrage proved fertile ground for event-driven managers in 2016. Total deal volume was lower than 2015, but managers generally profited from deals both large and small. The greatest areas of focus and, in many cases, sources of positive return were large global deals where regulatory and financing uncertainty created opportunity. Low interest rates and rising CEO confidence, coupled with the potential for lower corporate tax rates in the U.S., have many managers hopeful that activity will continue into 2017. Distressed credit managers were among the top-performing hedge funds in aggregate, but energy exposure was a source of significant manager dispersion. As oil prices bottomed in the first quarter, energy-related credit drove returns for distressed managers that bought into the space. However, managers that viewed the energy sector as a levered bet on the price of oil and were waiting for the emergence of bankruptcies and true restructuring opportunities lagged their peers as the credit rally persisted through year-end.
Outlook
Uncertainty. The fault lines where investors were focusing their attention at the outset of 2016 have been replaced with new areas of uncertainty. These include the impact of the Trump administration, upcoming elections across Europe and the subsequent impact on policies, and further concerns about a slowdown in China. As the calendar turned, the acute areas of investor concern have turned as well, but they have not disappeared nor are they likely to any time soon. This period of uncertainty is likely here to stay.
A new, non-traditional President will take office in the U.S. and there are upcoming elections in several large Europe countries, including France and Germany. This is a decidedly unusual time in geopolitics and the coming year is fraught with uncertainty. There is uncertainty surrounding the leadership in several large economic blocks and the staying power of the populist movement expressed in the Brexit vote and U.S. elections. There is uncertainty about the evolutions in policies that may follow any changes in leadership. Monetary policies have been such a critical force since the credit crisis; we believe any meaningful changes will likely lead to volatility. Once again, there is considerable uncertainty about the global economy, particularly the potential impact of a slowdown in China on the rest of the world.
We are in a period of uncertainty; uncertainty about geopolitics, about the future actions of central bankers, and about the global economy. Uncertainty can lead to volatility and volatility can be uncomfortable. However, this should not necessitate significant changes in the construct of an investment program. Rather, it should be used as an opportunity to reaffirm a focus on the long term and the benefits of rebalancing as asset prices diverge. When building investment programs with our clients, we strive to focus on the long term and to use thoughtful diversification to help weather periods of volatility and uncertainty.